A deferred ordinary share is a type of equity security issued by a company that has limited rights, particularly in terms of dividends and voting, compared to regular ordinary shares. The key characteristic of deferred ordinary shares is that they only provide financial benefits to the shareholder after certain conditions are met, often after a specified period or when certain company performance targets are achieved.
Table of Contents
Key Characteristics of Deferred Ordinary Shares
- Limited Voting Rights: Deferred ordinary shares often come with restricted voting rights. Shareholders might not have the same level of influence on company decisions as regular shareholders.
- Delayed Dividends: Dividends on deferred ordinary shares are typically paid only after dividends have been distributed to regular ordinary shareholders.
- Conditional Benefits: The financial benefits, such as dividends or capital returns, are contingent upon meeting specific conditions, such as company profitability or reaching a certain time frame.
How Deferred Ordinary Shares Work
The Process
- Issuance: A company issues deferred ordinary shares to investors, often to raise capital without immediately diluting control.
- Holding Period: Shareholders hold these shares but do not receive immediate financial benefits like dividends.
- Condition Fulfillment: Once the specified conditions are met, such as a set period or achieving certain financial milestones, the deferred ordinary shares may convert to regular ordinary shares or provide dividends.
Example
Scenario: Tech Startup Issuing Deferred Ordinary Shares
- Offer: A tech startup offers deferred ordinary shares to initial investors to raise capital.
- Conditions: The shares will only pay dividends after the company has been profitable for three consecutive years.
Investor A: Buys 1,000 deferred ordinary shares at $10 each. For the first three years, Investor A does not receive any dividends. Once the company reports profitability for three consecutive years, Investor A starts receiving dividends, similar to regular shareholders.
Investor B: Buys 500 deferred ordinary shares with a condition that they convert to regular shares after five years. After the five-year period, Investor B’s shares automatically convert, granting full voting rights and eligibility for dividends.
Types of Deferred Ordinary Shares
- Time-Based: Benefits are provided after a specific period.
- Performance-Based: Benefits are contingent on the company meeting certain financial targets.
- Hybrid: Combines both time and performance-based conditions.
Importance of Deferred Ordinary Shares
Benefits for Companies
- Capital Raising: Allows companies to raise capital without immediately diluting existing shareholders’ control.
- Performance Incentives: Aligns investor benefits with company performance, incentivizing shareholders to support the company’s growth and profitability.
- Flexibility: Provides flexibility in structuring equity to attract different types of investors.
Benefits for Investors
- Potential for Higher Returns: Investors may receive higher returns if the company meets performance targets or after the holding period ends.
- Alignment with Company Success: Investors’ interests are aligned with the company’s long-term success, as benefits are tied to performance.
- Lower Initial Cost: Deferred ordinary shares may be offered at a lower price compared to regular shares, making them an affordable investment option.
Advantages of Deferred Ordinary Shares
- Capital Efficiency: Helps companies raise needed funds without immediate financial obligations to shareholders.
- Incentivizes Performance: Encourages management and shareholders to focus on long-term success.
- Investor Appeal: Attracts investors willing to wait for potential higher returns linked to company performance.
Challenges and Considerations
Potential Issues
- Delayed Returns: Investors may have to wait for financial benefits, which could be a disadvantage compared to regular shares.
- Complexity: The conditions attached to deferred ordinary shares can add complexity to the investment and require thorough understanding.
- Uncertainty: Financial benefits are not guaranteed and depend on the company meeting specific conditions.
Ensuring Success
To ensure the success of a deferred ordinary share program, companies and investors should:
- Clear Communication: Clearly outline the terms, conditions, and benefits of deferred ordinary shares.
- Transparent Performance Metrics: Use transparent and measurable performance metrics to determine when conditions are met.
- Legal Documentation: Ensure all terms are legally documented to protect both the company and the investors.
Example in Practice
Real Estate Company
A real estate company issues deferred ordinary shares to fund a new development project. The shares will only pay dividends once the project generates rental income.
Investor X: Purchases 1,000 deferred ordinary shares at $20 each. For the first two years, there are no dividends as the project is under construction. Once the project is completed and starts generating rental income, Investor X begins to receive quarterly dividends.
Investor Y: Buys 2,000 deferred ordinary shares with a condition that they convert to regular shares after the project reaches 90% occupancy. Upon reaching the occupancy target, Investor Y’s shares convert, and they start receiving full dividends and voting rights.
Accounting for Deferred Ordinary Shares
From an accounting perspective, companies must properly record deferred ordinary shares to ensure accurate financial reporting. This involves:
- Equity Classification: Classifying deferred ordinary shares appropriately in the equity section of the balance sheet.
- Conditional Liability: Recognizing any conditional liabilities associated with the shares.
- Disclosure: Providing clear disclosures about the terms and conditions of deferred ordinary shares in financial statements.
Conclusion
Deferred ordinary shares are a versatile financial instrument that benefits both companies and investors. They provide companies with a means to raise capital without immediate financial obligations and offer investors the potential for higher returns tied to the company’s performance. Understanding the mechanics and benefits of deferred ordinary shares is essential for learners in accounting and finance, as it highlights the strategic ways companies can structure their equity and the potential rewards for patient investors.